Enhancing MSME creditworthiness: How to improve credit assessment outcomes

The recent budgetary push for increased credit availability for micro, small and medium enterprises (MSMEs) highlights the importance of credit funding for companies. India continues to lag in MSME credit penetration, clocking in at 14%, compared to 50% in the US and 37% in China, according to an EY report. The Indian financial sector is grappling with the underlying risk of lending to MSMEs, with delinquencies on MSME loans on the rise.

While budgetary measures and government support can help foster lender confidence, MSMEs need to focus on internal credit assessments for positive outcomes. The first step is to understand the lender credit assessment processes.

Risk rating assessments vs internal lender assessments

Risk ratings are a widely accepted measure of creditworthiness. They bring reputable, third-party credibility to the evaluation of the financial prospects of an MSME. While lenders rely on these risk ratings for internal credit assessments, they consider other factors as well, including:

• Funding proposal: How much funding is the MSME requesting? How will the funds be used? What is the capacity of the MSME to repay?

• Collateral and liens: What collateral is available for the proposed facility? Will it be cash flow-based (repaid from adequate cash flows), asset-backed (backed by a general pool of assets), or asset-based (size based on a specific pool of assets)? Are there any other liens on the collateral?

• History: Does the lender have a history with the MSME or the promoters? What is the size and desirability of the relationship outside of the facility being assessed?

• Internal portfolio construction: What overall exposure does the lender have to the industry that the MSME belongs to? Would this proposed facility fit within the internal risk constructs mandated for this asset category?

• Cash flow projections: A startup or an MSME’s projected cash flow in the next 3-5 years impacts the internal rating of the lender. It’s a dynamic rating that may change every quarter. How effectively is the borrower meeting the quarterly sales projections?

• Credit monitoring analysis or arrangement: A CMA report includes an in-depth study of a loan applicant’s actual and projected financial results and a report from a credit analyst or a banker. It is a critical document that illustrates a firm’s creditworthiness. Does the firm have an unsatisfactory report that may lead to a loan application being rejected?

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Potential initiatives to support risk ratings

An MSME can implement multiple financial and non-financial measures to prepare for lender credit assessments.

• Audited financial statements or detailed financial statements that are in line with accepted accounting standards.

• Business plan and financial projections that lay out the roadmap and align with its current performance and expected growth, with key milestones and measurable metrics.

• Quantum of debt, including the proposed financing, and whether it compares to industry metrics and whether the gearing ratios of the MSME are comparable to its competitors.

• Cash flow coverage which factors in the interest coverage ratio and the debt service coverage ratio. Some of the operational measures to explore include trying to get more favourable terms for supplier payment outflows and customer inflows.

• Off-balance sheet obligations including derivatives, future payment obligations and standby letters of credit.

• Equity cushion as evidence of promoter commitment and ‘skin in the game’ by not distributing all its earnings.

Some non-financial measures an MSME could undertake include:

• Governance: It should conduct regular internal assessments of its business and financial risk. Not only do these processes signal maturity and long-term commitment, but they also help identify and address potential issues proactively.

• Customer and supplier diversification: Besides fostering relationships with existing suppliers and customers, the company needs to actively expand its supplier and customer base.

• Supplier creditworthiness: It is equally important to assess supplier creditworthiness. While dependencies may be unavoidable in the early stages, an MSME should take steps to ensure minimal impact on operations due to downstream disruptions.

• Management: The experience and integrity of the management team play a big part. Employing a “KYC” approach for key hires and building ‘bench strength’ provide lenders assurance.

• Deep lender relationships: While keeping lender diversification in mind, consider consolidating promoter and MSME relationships at key financial institutions. A lender is more likely to favourably assess a proposed facility when there are other related transactions such as deposits to consider.

Finally, having an awareness of individual lender preferences helps. Which lenders have lent to similar industries? Is there continued appetite? Are there quotas that need to be filled? How has their existing loan book performed? However, this information is not publicly available. Having banking advisors to rely on is a great way to understand the lending landscape.

The push for internal credit assessments by MSME lenders is likely to continue. MSMEs should pursue strategies that put them in the best possible light with potential lenders. While tempting to focus on more immediate issues such as market share, cash burn and topline growth, investing energies and capital into a consistent risk management strategy will reap significant returns.  

(Rajat Chopra is Founder and CEO of fintech firm BankersKlub.)